Will US rates peak at 5.5%, as markets expect?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we ask whether markets are underestimating how much the Federal Reserve could raise rates.

 

Need to know: In 2008, groundbreaking research showed that markets tend to misjudge the Federal Reserve’s monetary policy in a cyclical fashion It showed a relationship that still holds: a particularly hot labour market and low credit spreads generally justify an underestimation of US rate hikes Today, spreads are too high to justify such a bias. Our analysis sees 5.5% as a credible terminal level for Federal Reserve rates

 

Challenging the story

Better-than-expected economic figures have been published over the past two weeks, challenging the disinflationary story that has been supporting markets. Now, markets are pricing a couple more hikes and then a return to the Federal Reserve’s (Fed’s) status quo, but the data show how the service industry remains strong. Should we keep faith in the Fed scenario? This year is not the first in which such a question has been raised – it preoccupied academia in 2008, which documented an interesting, stylised fact: markets are usually under-anticipating rate hikes when the employment market flies high. Could this be also the case today?

 

The market is wrong – right?

In 2008, economists Monika Piazzesi and Eric Swanson published a seminal paper on the relationship between monetary policy and financial markets.

The paper presents an econometric regression of the market’s errors in forecasting short-term rate Fed decisions, using two indicators of a tightening cycle  – US job creation and credit spreads. Their conclusion is clear: within a one-year time horizon, job creation explains 39% of the forecast errors and credit spreads 22%. These errors are calculated as the difference between six-month Fed fund futures and the Fed fund rates realised six months later. One of the messages of this essential ’macro finance’ study seems to be that the markets tend to misjudge the Fed's monetary policy in a cyclical fashion.

Figure 1 shows these forecast errors from 1999-2022 and compares them to the two measures of the cycle used by the authors. Their argument has not aged at all.

It is essential here to detail their discovery even further. It is twofold:

• On average and over the long term, markets are not wrong in their analysis of monetary policy. Their forecast is ’unbiased’, as the statistician in all of us would say.
• However, forecasting errors are persistent: in periods of growth, the markets tend to underestimate the Fed's ability to raise rates by about 10 basis points over the next six months, which is not very much. In a recession, the markets tend to underestimate the Fed's ability to cut rates by an average of 31 bps, which is a more significant number.

This cyclical game is now essential: with the January employment report and the compression of credit spreads from October 2022 to January 2023, markets are closer to being in the first scenario – the one in which the Fed’s propensity to raise rates is underappreciated.

 

FIG 1. Payrolls (left) and credit spreads (right) vs monetary policy forecasting error

Source: Bloomberg, LOIM

 

Where next for rates?

What is the message of Piazzesi and Swanson’s paper in our current context? With an employment report showing the creation of 517,000 new jobs and high-yield credit spreads hovering around 400-450 bps in the US, by how much do we expect forecasts to be off regarding the extent of rate hikes six months from here?

Figure 2 shows the evolution of the Fed policy rate and how it compares with the market’s view of how it will evolve (through Fed fund futures), and also how job creation and credit spread spreads are likely to affect these expectations. We can clearly see the improvement in the market forecast that comes from taking into account job creation and the level of credit spreads. Overall, job creation would justify an error of around 20 bps, but credit spreads remain above their lows. Once these two elements are combined, the forecast error should be close to zero, and the expectation of this monetary cycle peaking at 5.5% seems to make sense.

This is an important conclusion in terms of investment. In 2022, central banks violently surprised the markets, explaining most of the year’s performance. Such a surprise seems much less likely this year – and our monetary policy nowcaster will not say otherwise. It has fallen below 50%, the level indicating that dovish surprises are more likely than hawkish ones. The Fed's moderate tone in recent days is not inconsistent with this message.

 

FIG 2. Fed policy rates, Fed fund futures and cyclically adjusted forecasts

Source: LOIM, Bloomberg.

 

Simply put, the markets are probably right to expect the Fed policy rate to peak at 5.5%. As such, the Fed loses its status as their number one enemy. Who's next?

 

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

• The improvement in growth conditions is sticking for a second week in a row, essentially driven by the Eurozone. The growth nowcaster’s DI is now clearly above 50% as consensus builds behind Europe’s improving situation
• Inflation surprises should continue to be negative across the board: only the US has shown an uptick in the data this past week
• Our monetary policy nowcasting indicator has slipped below 45%, indicating that  dovishness is on the way
   

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

 

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

 

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